The Bush Administration is feeling the heat. While the State of the Union address highlighted significant GDP performance in the third quarter of 2003, the administration's greatest vulnerability is its inability to deliver on its promise to create new jobs. With job fears topmost in the electorate's collective mind, President Bush must present a coherent strategy for a job market stimulus in the upcoming elections. While economic advisors can present endless academic models that demonstrate the long-term effect of tax cuts on job growth, this viewpoint is vulnerable to Democratic political attacks that tax cuts are handouts to rich corporations that do not help the working class.
So what's the Bush Administration to do? In our opinion, tax reforms alone are insufficient to generate the desired job growth, because they only marginally benefit small-to-medium business enterprises (SMEs) that are the primary source of employment growth. For while S&P500 companies continue to export jobs from the domestic economy, the Small Business Administration (SBA) reports that SMEs are creating more than half of America's new jobs. SMEs are essential agents of growth in our market economy. But for robust economic growth to take place in this important sector, tax relief must be accompanied with regulatory reform.
Although existing regulation may be appropriate for large capitalization firms with a history of cash flows that can be evaluated using financial statement information, it represents an unfair operational tax upon SMEs. Entrepreneurial firms' lack of financial history inhibits valuations based on conventional techniques. SME appraisals are far from fundamental values that are revealed primarily through events that occur to the firm, such as a new contract or product announcement. SME investors rely more on their familiarity with management, affinity with the industry, and/or specific product knowledge than on conventional financial analyses.
Unfortunately, regulators fail to recognize that entrepreneurial SME firms differ from their well-capitalized brothers in terms of scale and valuation and to govern all with the same rules. The impact is that SMEs, for whom the costs for legal, accounting, and other requirements are often greater than the benefits, are unable to compete for the "sliver of equity" that they need for growth. This frustrates investment opportunities and economic development for job growth. Hence, one-size-fits-all regulation not only hurts the financial prospects of entrepreneurial firms and their ability to grow, but also has extremely negative consequences for American jobs.
The alternative to the existing regulatory paradigm is to divide governance of the capital market, like Gaul, into three separate regulatory regimes to mobilize capital for:
1. Government securities that are bought for savings accounts;
2. Top-tier issues that are bought for investment portfolios; and
3. Micro-cap SME stocks that are sold to speculators.
We propose a new approach specifically tailored for SMEs that trade in the micro-cap market that shifts the regulatory emphasis from investor financial capacity to investor financial capability. This regulatory approach would require the investor to demonstrate that she or he has sufficient sophistication to allow them to analyze and value young entrepreneurial firms without a history of cashflows. This approach differs significantly from the SEC's existing "accredited investor" approach, which is primarily focused on the degree to which the investor can self-insure.
A number of additional characteristics associated with entrepreneurial firms suggest that a focus on financial capabilities is well suited. First, entrepreneurial firms are characterized by constant transformation, as issuer characteristics change and markets develop. A regulatory model focused on investor capabilities has the adaptability to change as these developments occur; this adaptability can be contrasted to the conventional focus on financial data that requires change to be made in regulation, a process that is typically reactive and time-consuming.
Second, entrepreneurial markets are characterized by poor liquidity and imperfect competition. Given these characteristics, any system that reduces the proportion of investors that are unsophisticated will also have the benefit of limiting the diversions from fundamental value due to the prevalence of unsophisticated "noise" traders. Through limiting the investor universe to those that the regulator classifies as sophisticated, the noise trader effect should be greatly diminished.
Third, a regulatory model focused on self-tailored regulation can reduce the behavioral biases that result from the monopolistic nature of the conventional regulatory model. As law professors S.J. Choi and A.C. Pritchard argue, while markets correct themselves, regulators resist corrections. While competitive forces limit investor behavioral biases, the monopolistic nature of regulation removes these constraints. Regulators immobilize capital by unduly limiting alternative solutions to problems they face, such as an undue focus on disclosure. Regulators can behave reactively, suggestive of bounded rationality; place too much emphasis on realized events instead of the universe of potential events; and limit their problem-solving focus to realized effects. Regulators can focus too much on recent and available information, and perceive nonexistent patterns in random events. Regulators can suffer from overconfidence, confirmation bias, and group think. Beyond the monopolistic nature of regulation, these biases are exacerbated by a political system that requires immediate solutions in reaction to publicized scandals.
The American experience is itself an entrepreneurial experience. Yet the existing regulatory system fails small businesses in their entirety and acts as a barrier to job growth in this sector. "What you subsidize you get more, what you tax you get less" is a cardinal lesson of economics. As a nation, we have subsidized regulatory attorneys and big businesses while taxing SME job creation and innovation. The economic plank of the Bush Administration's 2004 platform must demonstrate the same enthusiasm for regulatory reform as it does for tax reform. Regulatory reform will stimulate the job market through removing barriers that prevent small business from accessing capital they need for growth. The candidate that seizes the initiative of providing job growth through real regulatory reform will have a considerable advantage in November.
Stephen A. Boyko is president of Global Market Thoughtware, an international consulting company. Aron A. Gottesman, PhD, is an assistant professor of finance at the Lubin School of Business at Pace University, and is the associate director of the William C. Freund Center for the Study of Securities Market.